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What You Need to Know About Special Dividends

Nicole Seghetti
December 10, 2012

In light of the looming fiscal cliff, many companies are choosing to pay special dividends before year-end. But before you get too excited about the extra coin you'll receive, there are a few things you need to know about special dividends.

On edge
As it currently stands, taxes on dividends are set to increase next year unless Congress averts the fiscal cliff. After the New Year's champagne has fizzled out, qualified dividends will be taxed at an individual's marginal rate, up from the current 15% flat rate. Due to this, many companies have elected to pay dividends -- their regular ones or special ones -- by year-end to save shareholders a potential tax bite.

But the most recent wave of dividends has been funded with debt. To take advantage of super-low interest rates, some companies including Costco (NASDAQ: COST), Carnival (NYSE: CCL), and Brown-Forman (NYSE: BF-B) are borrowing funds to pay their special dividends. According to The Wall Street Journal and Dealogic, corporate bond sales hit a record in November.

But Costco can get away with this take-from-Peter-to-pay-Paul strategy. Even though the company's long-term debt will triple after its new debt issuance, Costco is still less leveraged than its competitors, although that didn't stop Fitch Ratings from downgrading its bond rating of the company. Meanwhile, Brown-Forman, with its not-as-pristine balance sheet, also got its credit rating dinged after announcing a debt-funded special dividend.

Cash conundrum
Plenty of companies can fund special dividends using the cash in their coffers instead of taking on debt and tarnishing their balance sheet in the process. In fact, S&P 500 companies hold an estimated $900 billion in balance sheet cash, up roughly 40% from four years ago.

But many publically traded U.S. companies hold their cash abroad. Bringing it back to our shores would cost them a 35% haircut to Uncle Sam. With interest rates as low as they are, it's simply cheaper for companies to borrow money than it is for them to move their offshore cash back into the U.S.

Companies like Microsoft (NASDAQ: MSFT) and Apple